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While sterling volatility remains high and dominates the focus, there is no further visibility from UK prime minister Theresa May surviving the No Confidence vote yesterday. If this vote was meant to give her a stronger mandate, it has somewhat failed, with more than a third of her own party wanting her to step down in the 200-117 result.

Sterling positions could remain expensive to hold in both options time decay terms and on the risk of spiky movements on the next headlines. It is doubtful that May can wring any notable concessions from EU leaders as all of the action in the Brexit denouement is likely to remain on the home front from here.

The noise on Brexit and US-China trade talks has drowned out key developments in Europe, including a strong dip in Italy’s two-year BTP yield as budget negotiations with the EU are taking on a conciliatory tone. The EU summit today and tomorrow may put the issue behind us for now. The latest offer from Italy’s finance minister Tria is 2.05% of GDP, and the recent Yellow Vests protest in France is a game-changer as fiscal expansion announced by Macron will take France’s budget next year beyond the EU’s 3.0% growth and stability pact threshold.

As well, the new German CDU leader is a far more pro-European figure than the alternative and the pattern of populist revolt across Europe may finally be spreading to the EU’s capitals, even if the threat from the populists has not sufficiently penetrated the thick skulls on the EU commission. We are increasingly open-minded on positive euro developments, if not fully on board.

Building a EURUSD rally scenario

Probabilities still seem somewhat balanced, but in light of the last couple of days of developments, we are increasingly open to the idea that a combination of the following circumstances could lead to reasonable rally in EURUSD toward 1.2000, or at least into the 1.1700-1.1800 range in the coming weeks to couple of months, with the first four being the most important:

• Stable or lower Italian BTP yields (the large drop is an already underappreciated factor). • Deepening sense of a US-China trade ceasefire/stable USDCNY, even if the longer-term relationship remains rocky. • A dovish hike from the Fed or (much more forcefully) no hike at all at next week’s FOMC meeting. • A strong risk response to the Fed’s ongoing shift to a more neutral outlook. • US government shutdown over Trump’s insistence on border wall funding. • Brexit process pointing to a delay or an eventual second referendum.

Chart: EURUSD

Something has to give here as we’ve traded in a very tight range for over a month and spent the overwhelming majority of the last seven months in the 1.1300-1.1800 range. An upside break likely requires a combination of the factors listed above, while a downside break might require the opposite: an ugly turn in US-China negotiations, higher EU existential risks and an ugly deterioration in risk appetite.

Source: Saxo Bank

The G10 rundown

USD – tentative signs of a sell-off and we’re definitely not there yet, but a more notable breakthrough with China and a look at the action post-FOMC next week likely to spark a flurry of activity ahead of year-end.

EUR – changing our tune a bit on the euro for the short term if Italy’s budget situation is squared away at the EU summit here and risk appetite avoids any mishaps linked to US-China. The ECB today looks a non-event, with political developments in the driver’s seat across Europe now.

JPY – improved global sentiment not the stuff of a yen rally and yen likely to follow USD in directional terms in the crosses here.

GBP – sterling showing signs of resilience, but we steer clear given the lack of visibility – a notable technical development if GBPUSD can’t hold below 1.2700. EU Summit today and tomorrow could throw off further Brexit headlines.

CHF – CHF weaker as sterling weakness eases and as Italian yields plummet – more to come if euro sentiment improves, though we likely need a final answer on what Brexit looks like to get a more extended CHF sell-off.

AUD – held back by credit crunch concerns in the domestic economy, while further signs of progress in US-China negotiations could provide a countervailing force.

CAD – USDCAD not able to get comfortable here above 1.3400 and despite the dovish tilt from the Bank of Canada at its last meeting, a similar dovish tilt from the Fed next week and generally enthusiastic response from the market could mean that USDCAD remains capped here.

NZD – AUDNZD putting in a solid bounce after a hyper-extended NZD rally. Don’t know if we’ve posted a local low there, but next several months looks like more upside than downside potential.

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